Loans appear in many forms, from credit cards, to student loans, mortgages and when buying a car. Unless you become a gangster and use suitcases full of cash or watches as your means of transacting business, you will probably need a loan at some point in your life.
And keep in mind that just because you understand the mathematics of loans, you can still arrive at financial ruin by not having the discipline to follow what the math tells you. That is why there are so many depressed and depressing people in Las Vegas. They say that gambling was invented by God to punish people who are bad at math. Amen.
I. The Mathematics of Loans
When shopping for a loan, there are three numbers that you need to consider, all of which will change how hard it will be to repay your loan as well as how much money a bank will be making off of you.These numbers are (1) the interest rate, (2) the term, or length, of the loan, and (3) the monthly payment you will need to make to pay off the loan in the specified amount of time. Let's consider these in order, since they build off of each other.
(1) The Interest Rate
As the video in the Definition of a Bank post addressed, when a bank begins to loan you money, they charge you a fee to make sure that they continue to make money off of the money they lend you. This fee is called the interest, and controlling this rate is one of the most important concepts in the study of banking and money (at least, I think so, since I really have no idea).
Understanding interest mathematically is actually very subtle, and gives rise to some difficult concepts in calculus that we will not address here. Most simply, the interest rate represents a percentage of the amount of money being borrowed that you will have to pay off. So, if I were going to lend you $10,000 and charge you 15% interest, then one way to interpret this scenario is that you will need to repay me not only the $10,000 but also an additional 15% of $10,000 over the time you pay me back. In this case, that would mean that you would need to pay me an additional 1500$ beyond the original $10,000, making the total loan amount $11,500.
But unfortunately, loans are much more complicated than this. Instead of charging you a fixed percentage of your loan amount initially, most loans charge you a percentage of the amount you have borrowed over the amount of time you have borrowed it. So, let's say that you are charged 12% a year for a loan of $10,000. Then every year you are going to be charged 12% of the amount of money you borrowed. So, if the loan charges you interest once a year, then it might charge you 12% of $10,000 in the first year, or $1200.
But let's say that after one year you haven't paid back any of your loan. At this point, you owe the bank not just the initial $10,000, but $10,000 plus the extra $1200. So you owe $11,200 now, and the bank is going to charge you interest on it. So, now the interest isn't just on the initial $10,000, which would be an amount of $1200. It is actually 12% of the $11,200 you now owe the bank.
... to be continued . . .
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